The IRS, and many others both in and out of the Charitable sector, believe strongly that charitable contributions should be used for their intended purpose, and that the tax exemption granted to charities is a valued public trust. To ensure that the general public is getting the highest return from granting this benefit, the IRS wants assurance that charities are not using donations to compensate key executives more than a reasonable amount. The announcement in August 2003 that the New York Stock Exchange, a nonprofit corporation, compensated its chairman over $140 million a year was a watershed moment for the nonprofit sector and everyone knew the time for change had come.
To make sure your charity is making reasonable compensation decisions, the process of determining compensation needs to be performed using the IRS’s three steps detailed below to establish what is known as the rebuttable presumption.
The rebuttable presumption is a fancy term that means if your organization follows the correct procedures when making compensation decisions the burden of proof that the decision is unreasonable shifts to the IRS. These regulations were issued to help non-profits avoid overpaying key employees and others known as disqualified persons which includes anyone that was in a position to exercise substantial influence over the affairs of the organization.
Three Steps to the IRS’ Rebuttable Presumption of Reasonableness:
- The compensation arrangement or the terms of the property transfer are approved in advance by an authorized body of the tax-exempt organization composed entirely by individuals who do not have a conflict of interest with respect to the compensation arrangement or property transfer. An easy example of a conflict of interest would be if you were deciding the compensation level of your uncle.
- The authorized body obtained and relied upon appropriate comparability data prior to making its determination. Nonprofit compensation data is public information. The easiest way to obtain comparable data is to visit websites like Guidestar.org that make the IRS Form 990 available. Form 990 includes the payroll information for key employees in Part VII and Schedule J if employees are paid more than $150,000 per year. Download the data for a few organizations that you believe are comparable to yours. If you are small mental health clinic, downloading the 990 for a major nonprofit hospital most likely would not be viewed as using comparable data.
- The authorized body adequately documented the basis for its determination concurrently with making that determination. This means keeping good minutes of the deliberation, data relied on, and the reason for the decision.
Implementing the IRS criteria
There are many ways to implement these procedures and no one method fits all organizations. Larger organizations may establish a compensation committee and hire outside consultants to perform the function of evaluating compensation. Smaller organizations may assign this responsibility to a committee that already exists like the finance or executive committees or even the full board. The most important factor is that the required elements are present when making the decision.
The Tax Code imposes severe penalties when a determination is made that excess compensation has been paid
The penalty includes a two-tier excise tax on the excess benefit paid and the person receiving the excess benefit needs to return those funds to the charity with interest. The First Tier is 25% of the excess benefit, payable by the person who received it. If the excess compensation is not returned a 200% penalty can be imposed. In addition, a 10% tax may be imposed on the organization’s directors or officers who knowingly participated in making the compensation decisions.
Additional 21% Excise Tax on compensation over 1 million
A new provision is in effect for a tax year beginning after December 31, 2017. It has two components, a 21% tax on compensation payments in excess of 1 million and on separation payments, commonly called a parachute, when the payments are in excess of three times an employee’s average pay.
Many will agree that these policies in making compensation determinations make sense and seem like the right thing to do. To enhance compliance, the IRS added these policy questions into the IRS Form 990 so they and anyone who has access to your public information can determine if your organization is complying. This is especially true if you compensate anyone over $150,000 in a calendar year which requires the addition of scheduled (J) to the 990. This schedule not only has compensation data but also askes many more questions about your organizations compensation policies.